How Fannie Mae and Freddie Mac Guarantees Work

October 25, 2011

Though they do not garner as much media attention as they did in 2008, Fannie Mae and Freddie Mac continue to bail out mortgage investors through their guarantee programs, which do not operate much differently than they did before the recession. The idea here is that, once a local bank or a branch sets up a mortgage structure with a borrowing consumer, this mortgage is subsequently sold into a secondary market where government-sponsored enterprises (GSEs) like Fannie and Freddie will buy it up. They will then package it with other mortgages, creating a mortgage-back security, and sell the bundled product to investors in a tertiary market, says Anthony Randazzo Director of Economic Research for the Reason Foundation.

This would all move smoothly were it not for the agreement that accompanies the final sale: the GSE guarantees the securities for the investors, promising to continue payments on the mortgages even if the consumer stops paying. This became a problem in 2008 when many consumers stopped paying all at once, depleting the GSEs' excess reserves, causing insolvency and forcing them to default on their guarantees. Dealing in these subprime mortgages and non-liquid assets is what caused so much trouble for Fannie and Freddie in 2008, yet this exact practice continues to this day in much the same way.

The GSEs and Federal Housing Administration have bought or guaranteed 95 percent of all new mortgages thus far in fiscal year 2011, compared with 40 percent in the early 2000s.

Fannie and Freddie continue to post losses every quarter, yet receive subsidies from the federal government to keep them solvent -- these subsidies currently total $169 billion.

The Congressional Budget Office recently estimated that $51 billion more losses are likely for the GSEs over the next 10 years.

This places the issue in clear perspective: taxpayers and lawmakers decry the use of bailouts to save irresponsible lenders, yet the practice continues to this day. Though the funding is coming in smaller packages, the fact that it continues at all is the true problem. Taxpayers should be outraged that the financial industry seems so content in its ethically dubious practice, and further outraged that this exercise is facilitated by compliant politicians in Washington.